Article: The Limitations of In-House Business Valuation

December 2005


	Lynn Westergard

The limitations of in-house business valuation

Formula-based or intuitive valuation approaches may be fine for internal use, but satisfying the IRS is another matter

The October 2005 results of Schmidt Westergard & Company’s quarterly survey, the East Valley Business Pulse, included some interesting data about local business owners’ knowledge of their company’s value, their purposes for determining value, and the manner in which they ascertain it.

According to the survey:

Nearly 75% of business owners and managers know their business's fair market value, within a 10% margin of error.
Sixty-five percent of respondents who had recently valued their company did so for the purpose of purchase or sale, estate planning, or creating an ESOP (employee stock ownership plan).
About 30% based their value on the company’s earnings/and or equity; just over 40% used a valuation formula that they believed was applicable to their business; and 30% relied on the findings of a business valuation professional.

As valuation professionals, it is tempting for us to assert that all business valuations should be turned over to an outside expert; as a practical matter, though, internally utilized rules of thumb and valuation formulas work just fine in some instances, especially when satisfying a third party is not an issue.

However, if third parties – such as the IRS or a lender or investor – have more than a passing interest in the value of your company, in the context of, say, estate planning or ESOP formation, a do-it-yourself valuation probably won’t pass muster. In fact, a valuation that doesn’t stand up to legal challenge can have devastating consequences for you and your company.

Business valuation is neither a science nor an exercise in mathematics; it is an art. If there were, in fact, a simple formula, there would be no difficulty in valuing a business.

Unfortunately for champions of simplicity, the IRS raises numerous value factors, many of which are subjective and open to interpretation, that are to be considered in the valuation process. Also, the purpose of a valuation often affects the approach and outcome. Valuation of a business may be for many reasons other than a sale or purchase and may include a transfer of shares, gifts of stock to your children or other family members, or stock options to key employees.

Intangibles. To satisfy the IRS, one must look beyond the tangible financial data and ratios and consider a long list of complex intangible questions that generally include the following:

What are the local economic conditions? A business in an economically depressed area may not be as valuable as the same business located in a thriving market.
What is the overall health of the industry of which the subject company is a member?
How will changes in technology affect demand for the business’s products and services, and how easily will the business adapt to those changes?
What is the ownership structure? A business run by a sole proprietor may have less of a chance for future success than one that is part of a large corporation.
What is the business’s capacity for earnings and the payment of dividends?
What are the intangible assets of the business? Foremost among them may be the value of name recognition, goodwill and the company’s customer list.

Other considerations. Prior sales of businesses are an excellent measure as well. If a similar business sold recently, the amount of that sale certainly would be a measure to consider.

The price-earnings multiple of publicly traded companies can also be examined for comparative purposes. Your business may not be as large as a public company, but the financial information that public companies disclose may be helpful in the valuation process.

Other questions to be addressed include: Does the business have an indispensable supplier? Does the business have an indispensable customer? Does the business own any patents or copyrights? When do they expire? What are the nature, level, and skill set of the business’s work force? Do the physical plant and technology infrastructure meet both current and future needs?

And if those issues aren’t enough to make you reconsider the reliability of your in-house valuation, now factor in the impact of your buy-sell agreements, executive compensation, organizational charts, and the viability of the business without you at the helm.

Conclusion. As was stated earlier, formula-based or intuitive valuation approaches can be very useful for business owners who wish to arrive at a value number that must satisfy no one but themselves. However, the complexity and subjective nature of the art of business valuation, compounded by the demands of third parties and possible legal adversaries, make the use of independent valuation professionals a virtual necessity.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.